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The MPC and the Investment Multiplier

If the investment community increases itsspending, incomes and consumption will

spiral upward in multiple rounds of earning

and spending.

Once the process has played itself out, the

economys equilibrium income will behigher by some multiple of the initial

investment spending.

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Concept of Investment MultiplierConcept of Investment Multiplier

When the Investment increases by Rs.100cr, theWhen the Investment increases by Rs.100cr, theincome of people will increase by 100cr.income of people will increase by 100cr.

But this is not all.But this is not all.

The people who will receive this amount ofThe people who will receive this amount ofRs.100cr, will spend a good part of this onRs.100cr, will spend a good part of this onconsumer goods.consumer goods.

Suppose the MPC is 0.8 (i.e 4/5), then out ofSuppose the MPC is 0.8 (i.e 4/5), then out ofthis amount of Rs.100cr, they will spendthis amount of Rs.100cr, they will spend

100 X 4/5 = 80 crs on consumer goods.100 X 4/5 = 80 crs on consumer goods.

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The providers of these consumer goodsThe providers of these consumer goodswill earn Rs.80crs & in turn spend MPC =will earn Rs.80crs & in turn spend MPC =

0.8.0.8. So they will spend 80 X 4/5 = 64crs andSo they will spend 80 X 4/5 = 64crs and

this chain will continuethis chain will continue

This can also be obtained by 100 X (4/5)This can also be obtained by 100 X (4/5)2

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The 45-degree line represents all possible

income-expenditure equilibria: Y = E. (But,of course, there is only one point along that

line that corresponds to full employment.)

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Consumption behavior is given by a linear

equation C = a + bY. In this economy, theslope b, also called the marginal

propensity to consume, is one-half, or 0.5.

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Investment spending is added vertically to

consumption spending: C + I is totalspending for a wholly private economy.

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The economy is settled into an initial

equilibrium where Y (measuredhorizontally) is equal to C+I (measured

vertically).

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Now suppose that increased optimism in

the business community causesinvestment spending to increase by (I .

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The increased investment ((I) causes the economy to spiral upward

to a new equilibrium, where the level of income is higher by (Y.

Note that the increase in income ((Y) appears to be about twice the

increase in investment ((I).

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A second wholly private economy differs

from the first one only in terms of theslopes of their consumption equations.

This second economys MPC is 0.8.

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Notice that with a high MPC, this

economy is sensitive to even a smallchange in investment spending.

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A small increase in (I drives income up by a substantial (Y.

Note that in this economy, the increase in income ((Y) appears to be

several times the increase in investment ((I).

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The consumption equation in this third

economy is almost flat. Its MPC of 0.1means that people spend only ten rupees

out of each additional hundred rupees

that they earn.

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Only a very substantial increase in

investment can have an effect on incomecomparable to that of the other two

economies.

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The increase in income ((Y) doesnt

appear to be much larger than the

increase in investment ((I). In the limiting

case, where MPC = 0, there is no

spiraling at all, and (Y = (I.

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The MPC and the Investment MultiplierMore generally, the multiple that relates (Y

to (I is dependent on the MPC, which is

simply b in the equation C = a + bY.

We can actually calculate an expression inthe form of(Y = (some multiplier)(I

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Y = C + I, where C = a + bY

Eq. 1.: Y = a + bY + I

Suppose I changes by (I such that Y changes by (Y. The new

equilibrium is:

Eq. 2.: Y + (Y = a + b(Y + (Y) + I + (I

Now, how do you find the difference between Equilibrium 1 and

Equilibrium 2?

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Eq. 2.: Y + (Y = a + bY + b(Y + I + (I

Eq. 1.: Y = a + bY + I

(Y = b(Y + (I

(Y - b(Y = (I

(1 b )(Y = (I

(Y / (I = [ 1/(1 b )]

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Multiplier ( K ) = 1/(1 b )

1/(1 b ) is the investment multiplier.

We can say, then, that if investment spending

increases by (I, then the equilibrium level of

income will increase by 1/(1 b ) time that

increase.